Necessary But Not Sufficient

By John Mauldin

June 11, 2012

We woke up this weekend to a €100 billion “rescue” of Spanish banks, and the initial reaction of the market was relief. But did we not just see this movie, but with Greek subtitles rather than Spanish? Was this another of those “necessary but not sufficient” plot lines that Europe is so good at? Kick the can down the road and hope for a happy ending?

Pardon my skepticism, but I see numerous problems. In the first place, €100 billion will not be enough. While the current estimates are closer to €40 billion (if you ask the Spaniards), JP Morgan estimates it will be more like €350 billion. Others estimate more or less, but €100 billion is decidedly optimistic. Even the Spanish authorities are acknowledging that there is another 35% downside for the housing market, which is the main source of the losses. It appears that has NOT been included in the guesstimates.

Secondly, this saddles Spain with yet more debt, which will force the rest of already-sold Spanish debt into a subordinated position (more on that from Louis Gave, below). It does not address the problem that Spain is running an almost 10% of GDP deficit and will need to access the markets for very large sums in the near future. For all intents and purposes, they have been shut out of the bond market, which is why they needed a “rescue.”

Third, it does not address one of the fundamental problems, which is the subject of this week’s Outside the Box from Charles Gave: it does not help solve the trade imbalance between Germany and the periphery nations.

Germany has two very bad choices. It can finance the multiple trillions of euros of debt of Spain and Italy (and France), converting it into eurozone debt, while giving up its own fiscal sovereignty and allowing a eurozone-wide fiscal union and taxing authority; or the Germans can spend trillions of euros allowing the eurozone to break up, either by exiting themselves or allowing the southern countries to exit.

The market is not going to finance Spain, Italy, et al. in the short term (i.e., this year). That means the ECB will have to print money or some European entity will need to have a basically unlimited blank check at the ECB, if those countries are not allowed to default on their debt. Someone, or some group of someones, is going to have to write a rather large check. The question is whether it costs more to stay or to go. Germany leaving the euro would not be good for German exports, which are 40% of their economy.

Finally, it is not clear exactly how this bailout (let’s call a spade a spade) is going to come about. There will have to be, I assume, agreement from the eurozone countries if the EFSF or ESM funds are to be used. Further, if you make this deal for Spain, then Greece, Portugal, and ESPECIALLY Ireland are going to demand a reset. I am sure there is a coherent plan here somewhere, but I can’t find it as of Monday night. What I did find is this quote in the Financial Times (jumping to the end of the story):

” ‘Many Irish people looking at the deal this morning will be asking themselves why is there one set of conditions for us and another for Spain,’ said Mr Doherty. Ireland’s economic crisis closely resembles the situation in Spain, where a property crash has morphed into a banking crisis, leading to calls that Dublin should renegotiate its existing EU-IMF bail out deal. Aware that it is unlikely to persuade the troika to reopen its own bailout program, however, Dublin moved quickly on Sunday to deny that Spain’s program would be less onerous than its own.

“The Spanish program could also produce political problems outside current bailout countries, particularly over the issue of which of the eurozone’s two bailout funds is used for the rescue.

“Dutch and Finnish officials have warned they do not want the new bailout funded through the existing rescue system, the €440bn European Financial Stability Facility, because its lending is treated like any other private lender, meaning it has no seniority in the repayment queue.” (emphasis mine)

The Spanish prime minister played the Germans very well. He got what appears to be a much better deal than the Irish. But then, he was playing hardball. This note from Joe Weisenthal at Business Insider:

“According to El Mundo, Spanish PM Mariano Rajoy sent a stunning text message to FinMin Guindos prior to the bailout negotiations. He said, according to El Muno editor Pablo Rodriguez:“Resist, we are the 4th power of the EZ. Spain is not Uganda.” Translation: We’re a major power, not some random IMF-case banana Republic.

“The followup message (according to Google translate) “If you want to force the redemption of Spain will prepare 500,000 billion euros and another 700,000 for Italy, which will have to be rescued after us.”

“Bottom line: hold out for something good. We are powerful, and if they don’t give in, the whole thing will go down. It will cost Europe 500 billion if Spain goes bust, and then another 700 billion if Italy goes bust. No wonder Der Spiegel, which represents the German point of view, has an article blasting Spanish blackmail.”

And before we get to Charles’s piece, let’s look at this quick analysis by his son Louis Gave, the CEO of GaveKal, writing from Hong Kong ( www.gavekal.com):

“As we go through the few scant details of the bank bailout offered to Spain, we cannot help but shake an uneasy feeling of deja-vu all over again:

Banks confronting a deposit flight – check.

Sovereign shut out from debt market – check.

Loans provided to help sovereign deal with the situation – check.

Potentially pushing current sovereign debt investors into a subordinated position – check.

“It is on this last point that the Spanish ‘bailout’ could prove to do more harm than good. Indeed, as we highlighted with Greece, when policymakers transform government debt into subordinated debt, they may as well shut down that market for good. This for a very simple reason: most investors who buy government debt do so on the premise that the paper is the most ‘risk-free’. These are not equity investors, carefully weighing the risk-reward of a current asset.

“Investors into sovereign debt are all about minimizing risk. The reason one buys government bonds is first and foremost for capital preservation and portfolio diversification. Subordinated debt does not meet those requirements. Thus, Europe’s policymakers, from one day to the next, could potentially not only increase the Spanish debt load by 9% of GPD but simultaneously make Spanish debt considerably more risky, and thus more unattractive. Beyond an immediate knee-jerk reaction, it seems unlikely that the Spanish contraction in spreads will be meaningful or lasting.”

What Europe did over the weekend was put a band-aid on a very deep gash. To actually fix the problem, Europe must remove bank liability from the various nations and make them joint and several. But that is going to be something that Germany and other nations will fiercely resist. When the dust settles, the markets will realize, I think, that this latest move did not solve the real problems. It was just a way to stop the immediate pain. There is more to come, and it will require a lot more money and the loss of a great deal of national sovereignty if the eurozone is to hold together. It took the US decades, if not a century, to get to that place. Europe has a few years under its belt at most, and the crisis is right on top of them.